Stock Options Aren’t Dead –

Open any business periodical and you will find an obituary for the stock option. This once-powerful form of employee compensation has gone the way of the dinosaur, we learn, for two reasons. First, the nasty Federal Accounting Standards Board (FASB) has decided that companies issuing options must record an expense at the time of the grant. Second, now that the stock market has fallen so dramatically from its peak, many employees find their options under water, thus the instrument is no longer working its incentive magic.

Although public companies currently disclose their imputed option expenses in footnotes to their financial statements, some factions in the financial community feel that this compensation element should more properly be included in a company’s standard earnings report. The impact varies, of course, from one company to the next, but in some cases it changes the numbers for a given year from a profit to a loss – not something any company looks forward to.

Microsoft has declared that stock options, despite having minted scores of millionaire Microsofties, are no longer doing the job. It’s going to switch to restricted stock grants, giving employees something that will be valuable regardless of which direction the stock heads. And that fact means that they can grant fewer shares than they would with an option instrument, so the expense hit will potentially be lower. Both of our fundamental issues have been addressed – problem solved. In addition, no public relations campaign could have gotten the company as much positive, front-page news coverage.

While a number of larger firms are reported to also be switching to restricted stock or other alternatives, some are holding out, claiming options still have their advantages. But the popular press explains that this is probably the beginning of the end. The fuel that has powered innovation and hard work in the startup environment over the past several decades has run its course.

Slow Down

Not so fast. The factors that influence the attractiveness of options for mature companies do not necessarily apply to startups. A closer look shows that options continue to be an important instrument for executives, employees and investors in early-stage companies. Neither of the headline-grabbing option detraction factors is significant for these firms.

Between 1950 and 2000, the Dow Jones Industrial Average rose from roughly 200 to about 11,500, for an annualized gain of approximately 10%. Of course, some sectors have fared better than others, and certain companies have managed to significantly outperform the market. The stratospheric rise in the market a couple of years ago lifted almost all the players, and perhaps we got too comfortable with the notion that, given a little bit of time, any given stock would move up in price. An option issued with a strike price close to the current trading price, the theory goes, would no doubt be “in the money” as it vested in a year or two.

With the market bust, that theory was dashed. Not only are certain older options now virtually worthless, but employees are reluctant to get too excited about newly issued options, given the recent roller-coaster history of the market and the realization that the bubble is not likely to repeat itself any time soon. So it makes sense for established companies to look for other ways to reward their employees.

But the situation is much different – or perhaps we should say, much unchanged – for startups. At the very beginning, the business is virtually worthless: Its stock price can’t go much lower. An entrepreneur who accepts stock options early in a company’s life is unlikely to see the price drop. The more likely outcome is that the company will go out of business. Of course, what everybody is hoping for is that the startup grows and prospers, and option-holders stand to realize a substantial reward. That’s the way it’s supposed to work.

The option-holding entrepreneur has another advantage. Typically, option grants are for common stock. The common stock of a startup is not publicly traded; in fact, in many cases, there are no transactions early on to explicitly establish the price of the common stock. Venture investors usually buy preferred stock. In most cases, a determination is made that the common stock, which doesn’t have the liquidation preference and other advantages of the preferred, is worth, on a per-share basis, a fraction of the price paid for a preferred share – usually one-tenth that amount. So, if investors are buying preferred shares for $2 each, employees are issued stock options with a strike price of 20 cents. As the startup progresses, later financing rounds might drive the preferred price up to $5, and the option price hits 50 cents. As the company morphs into a legitimate business and a positive outcome becomes likely, the risks associated with the common stock are lessened, and options issued during this stage might carry strike prices that are 25% to 75% of the preferred price.

In the ideal outcome, our startup goes public (or gets acquired) for perhaps $12 per share. Common stock and preferred stock are merged. Our option holders can choose to exercise their options at the original strike price and then sell their shares for significant gains. Depending on the specifics, there can be tax advantages as well. Clearly this is an attractive scenario for the employees. It is this potential outcome that has allowed startups to attract the best and the brightest, despite the hard work and long hours that come with the job. In fact, stock options help a startup conserve cash by holding down compensation outlays. Investors are comfortable with the technique because it creates a win-win scenario: If the employee team can build a business with significant value, all parties will reap sizable rewards.

No Problemo

But what about the other “big problem” with stock options – those pesky accounting issues? If the startup (just like the mature company) is using options as an element of compensation, surely that needs to be addressed in its financial reports. And it is. While private, the startup discloses to current and potential investors extensive details about stock options already issued and about the pool of shares available for option issue in the future. Generally, each and every stock option grant is approved by the board of directors. And that board is the one that sets the strike price for the options, so investors are fully in the loop.

As the company prepares to go public, the option situation is again subject to careful scrutiny. The underwriters will make careful study of the options that are issued and outstanding and will fully disclose the situation in the prospectus and associated documents. If there are lock-up agreements that prevent option holders from selling before a certain time, those will be disclosed as well. Analysts assessing the stock’s future prospects will also weigh in on any impact associated with options. Thus, investors contemplating purchasing the startup’s stock at or near the public offering will have plenty of information available to determine dilutive effects from employee stock options.

Just like the bigger companies, the startup will be required to account for the options as an expense in its financial reports. It still isn’t clear what the magnitude of that expense hit might be for a startup. The rules for how to account for a stock option’s value still haven’t been finalized. But even if the option expense depresses (or wipes out) stated earnings, investors are going to look beyond the P&L statement, focusing instead on cash flow and the company’s prospects. The new accounting rules aren’t changing the fundamentals of the business; they’re only changing the way the information is presented.

So let’s put the option obituaries back in the file. While market shifts and accounting rules certainly are causing mature companies to reconsider how to structure the stock element of their compensation plans, startups will likely stay the course. Options have been a tremendously powerful tool for these firms, and all indications are that that should, and will, continue to be the case.

George Hoyem and Bart Schachter are managing partners of Blueprint Ventures. Based in San Francisco, Blueprint is an early-stage venture firm with two funds under management. Hoyem’s investment focus is software, wireless, security, and other IT and communications infrastructure companies. Schachter focuses on communications and IT infrastructure, wireless technologies, nanoelectronics, software, and communications semiconductors.